Sunday, 1 September 2013

Selgin v. Summer

Over at the Free Banking blog the ever interesting George Selgin has a post discussing why Austrian cycle theory and monetarist explanations of booms and busts are not mutually exclusive. Selgin writes,

Having learned my monetary economics from both the great monetarist economists and their Austrian counterparts, I've always chafed at the tendency of people, including members of both schools, to treat their alternative explanations of recessions and depressions as being mutually exclusive or incompatible. According to this tendency, a downturn must be caused either by a deficient money supply, and consequent collapse of spending, or by previous, excessive monetary expansion, and consequent, unsustainable changes to an economy's structure of production.

During the 1930s and ever since, this dichotomy has split economists into two battling camps: those who have blamed the Fed only for having allowed spending to shrink after 1929, while insisting that it was doing a bang-up job until then, and those who have blamed the Fed for fueling an unsustainable boom during the latter 1920s, while treating the collapse of the thirties as a needed purging of prior "malinvestment." As everyone except Paul Krugman knows, the Austrian view, or something like it, had many adherents when the depression began. But since then, and partly owing (paradoxically enough) to the influence of Keynes's General Theory, with its treatment of deficient aggregate demand as the problem of modern capitalist economies, the monetarist position has become much more popular, at least among economists.

It is, of course, true that monetary policy cannot be both excessively easy and excessively tight at any one time. But one needn't imagine otherwise to see merit in both the Austrian and the monetarist stories. One might, first of all, believe that some historical cycles fit the Austrian view, while others fit the monetarist one. But one can also believe that both theories help to account for any one cycle, with excessively easy money causing an unsustainable boom, and excessively tight money adding to the severity of the consequent downturn. I put the matter to my undergraduates, who seem to have little trouble "getting" it, like this: A fellow has an unfortunate habit of occasionally going out on a late-night drinking binge, from which he staggers home, stupefied and nauseated. One night his wife, sick and tired of his boozing, beans him with a heavy frying pan as he stumbles, vomiting, into their apartment. A neighbor, awakened by the ruckus, pokes his head into the doorway, sees our drunkard lying unconscious, in a pool of puke, with a huge lump on his skull. "What the heck happened to him?," he asks. Must the correct answer be either "He's had too much to drink" or "I bashed his head"? Can't it be "He drank too much and then I bashed his head"? If it can, then why can't the correct answer to the question, "What laid the U.S. economy so low in the early 1930s?" be that it no sooner started to pay the inevitable price for having gone on an easy money binge when it got walloped by a great monetary contraction?

This not just a good piece of marriage advise, it is also a good piece of economic advise, one which is missed by many economists who see the Austrian and monetarist views as mutually exclusive.

Selgin goes on to argue that modern economists, including Scott Sumner, have been sucked into a false dichotomy:

Sumner basis his position, not merely on the claim that prices are more flexible upwards than downwards, but on a dichotomy erected in the literature on asset price movements, according to which upward movements are either sustainable consequences of improvements in economic "fundamentals," or are "bubbles" in the strict sense of the term, inflated by what Alan Greenspan called speculators' "irrational exuberance," and therefore capable of bursting at any time. Since monetary policy isn't the source of either improvements in economic fundamentals or outbreaks of irrational exuberance, the fundamentals-vs-bubbles dichotomy implies that monetary policy is never to blame for changes in real asset prices, whether those changes are sustainable or not. If the dichotomy is valid, Sumner, Friedman, and the rest of the "monetary policymakers shouldn't be concerned about booms" crowd are right, and the Austrians, Schwartz, Taylor, and others, including Obama and his advisors, who would hold the Fed responsible for avoiding booms, are full of baloney.

I’m happy to reassure George that I do not believe the things he claims I believe. I believe the Fed often creates booms, and that these booms often lead to recessions. So in that sense my views are quite Austrian. I am particularly surprised by his claim that I don’t believe that monetary policy affects real asset prices, as he recently commented on a post that was devoted to exactly that proposition:

Now here’s where I part company with Keynesians who might have been with me so far. Although short term interest rates are one of those “asset prices” that cause the money market to achieve near instantaneous equilibrium, even as the goods and labor markets are in disequilibrium, they actually have very little role in moving NGDP and prices to the level necessary to restore long run macro equilibrium (and to move interest rates back to their original level.) In my view 60% of the heavy lifting is done by what Keynes called “confidence” and I call “expectations of NGDP growth” and Ford Motors economic forecasters call “expected nominal incomes in 2014 available to buy Ford cars.” Another 35% of the transmission is done by asset markets like stocks, forex, commodities, real estate prices, junk bond yield spreads, etc. And maybe 5% by risk-free short term rates. At most.

So I just claimed that 35% of the transmission effect of monetary policy works through changes in real asset values, and have been saying similar things all along. George is a smart guy, so clearly something I said was misleading, or created a false impression. Perhaps it’s my denial of “bubbles.” I believe in the EMH (i.e. no bubbles), but only for asset markets. Because goods and labor markets have sticky wages and prices, they are not efficient, and monetary stimulus creates booms and busts in terms of output. In some cases, such as the 1970 recession, the blame is almost 100% the preceding boom. Indeed the preceding boom also played a big role in the next few recessions. Where I differ from some Austrians is that I believe the preceding booms in 1929 and 2007 were not major factors in the subsequent slump. In those two cases I think tight money is mostly to blame, perhaps 90% or more. It’s hard to be more precise as the trend line is a judgment call (in the absence of NGDPLT.)

Summer goes on to say that he sees booms and bubbles as unrelated phenomenon. If by boom we mean "excessive nominal spending" then he doesn't see a strong correlation between booms and bubbles.

2 comments:

It depends on what the cause of the problem is in the first place. If, for example, it is the central bank fuelling an unsustainable boom then cutting back on monetary growth and letting the needed purging of prior "malinvestment take place would seem the answer.